Ryan ALM, inc. Asset/Liability Management The Solutions Company Pension Solution: Buy Time Ronald Ryan, CEO, CFA ___________________________________________ Most pension funds have been hard hit with skyrocketing contribution costs in this decade that are projected to spiral upward in the next five to 10 years. To stem this budget crisis, many pensions are adjusting asset allocations and investment policies to venture more into new investment alternatives. Most non-bond investments take time to reach their full potential or target ROA. To accommodate this strategy asset allocation models should be programmed to …buy time! What does this strategy look like and will it work? Time Horizon(s) Although most pensions face deep deficits, they have time to correct or remedy this situation. The logical amount of time pensions should use as an investment horizon is the average life or duration of their liabilities. However, the Pension Protection Act (PPA) requires seven years for corporations and 10 years for Multi-employer plans (with a five year extension if requested) to cure these deficits and move the funded ratio into an acceptable area (@ 90% +). GASB seems to allow public plans up to 30 years which is well past the average duration of liabilities (usually 10 to 15 years). To buy time suggests that the asset allocation is modeled in such a way not to invade or disturb the non-bond (i.e. Alpha assets) allocation so it has time to outgrow liabilities and cure the deficit. Normally, pension benefit payments are paid for initially through contributions. If these amounts are not sufficient then the next source of funds comes from the current assets. It is the bond assets that should fund the net liabilities after contributions. Bonds should be arranged in maturity or duration order to fund liabilities chronologically so the Alpha assets are not invaded to make the liability payments. Bond Management Traditionally, bonds are managed vs. the Lehman Aggregate or Government/Corporate Index (indexes I designed as Head of Research at Lehman) as their benchmark. Unfortunately, the PIPER study shows a consistent record of poor performance in this asset class which I reported on in my research paper “No Alpha in Bonds” (go to www.RyanALM.com/Research). Ryan ALM, Inc. - The Solutions Company www.ryanalm.com The Solutions Company PIPER Study of Fixed Income Managers Taxable Separate Accounts Annual Total returns (10 years ending 12/31/08) 1st Quartile Median Lehman Aggregate Lehman Govt/Corp 5.75% 5.22% 5.63% 5.64% © 2009 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. The PIPER study shows the Median bond manager loses to the Lehman Aggregate bond index for the last 10 years. After fees, the 1st quartile manager loses to the Lehman Aggregate too! If 50% to 75% of the managers of an asset class lose to their benchmark index consistently over time, this is strong evidence that you index this asset class. The question then becomes what index to use. The obvious answer is a Custom Liability Index (CLI) that best represents the true objective of the pension plan. Once installed, bonds can now be managed as a Liability Index Fund or Liability Beta portfolio. Custom Liability Index (CLI) The CLI is based on the actuarial projections of the future annual benefit payment schedule. Ryan ALM provides both a gross and net CLI (minus annual Contributions). Accordingly, the CLI is pricing the actuarial projections at the market daily to create a series of reports (Structure, Performance, Interest Rate Sensitivity). The CLI provides all the data to calculate the economic Funded Ratio which supports the Asset Allocation decision. It also provides the data for Performance Measurement (asset growth vs. liability growth). The CLI bridges the gap between the liability side and the asset side. Most assets require an index benchmark or they don’t understand the risk/reward behavior that the client is demanding. Actuarial reports are very tedious and comprehensive documents that usually are produced annually months delinquent. Such reports are not presented as an index with risk and reward calculations or even the projected liability benefit schedule. It would be hard for any asset manager to manage to an index if it came out annually, months delinquent with no tangible index portfolio and frequent return history. Liability Beta Portfolio Defeasance, Dedication, Immunization, Prefundings, Lotteries, etc. have all demonstrated for decades the best value of fixed income is its ability to match and fund liabilities. As the PIPER study of fixed income asset management has proven, there is little value added in actively managing bonds. If a pension has a deficit, bonds could not match and fund all the liabilities. Moreover, there needs to be a heavy allocation to non-bonds (the Alpha assets) to outgrow liabilities and cure the deficit. Bonds should be the core portfolio whose mission is to match and fund liabilities chronologically. Suppose there is a 20% allocation to bonds. After Contributions, this bond allocation might be able to match and fund the next eight years of liabilities. The deficit to be cured and financed is now moved to longer liabilities which buys time for the Alpha assets to outgrow liabilities. As the economic Funded Ratio (market value Ryan ALM, Inc. - The Solutions Company www.ryanalm.com The Solutions Company of assets/liabilities) improves, the Asset Allocation should respond and transfer more assets to the bond side to match more liabilities chronologically thus buying more time for the Alpha assets to perform. The more time the Liability Beta buys the better the odds of success. Most important, the Liability Beta portfolio will reduce interest rate risk and the volatility of Contributions since it matches liabilities and requires no contribution in the Beta space. Asset Allocation A Funded Ratio with a surplus should have a different asset allocation that if it had a major deficit. The focus of asset allocation should be on the true economic Funded Ratio (market value of assets/liabilities) not the ROA. As the Funded Ratio improves there should be a shift in asset allocation towards more bonds (i.e. Liability Beta Portfolio) matched to liabilities. In the late 1990s most pensions had surpluses. It would have been wise to shift the asset allocation towards bonds matched to liabilities to secure this surplus. Because most plans focused on the ROA they did not shift their asset allocation to bonds since bond yields were too low to validate the ROA. This decision has damaged most pension plans solvency and their plan sponsors budgets. Asset Allocation should be viewed as a dynamic process since the Funded Ratio is indeed volatile. This is described as Tactical Asset Allocation. It requires frequent monitoring. Every time assets are reviewed, liabilities should also be reviewed. This would focus on the true economic Funded Ratio. Based on this Funded Ratio, a decision on adjusting asset allocation should also be reviewed. Too often asset allocation is a static, delinquent process reviewed annually or even triennial. Since asset allocation accounts for over 90% of the total return of any client, it is the most critical asset decision and needs to be monitored often with accuracy. Without a Custom Liability Index, the market value of liabilities is not known and the true economic Funded Ratio is not known. As a result, asset allocation can not function effectively. This has been the sad story for most pensions in America for a long time. Ryan ALM, Inc. - The Solutions Company www.ryanalm.com